Let’s Debate: Crypto, Crypto, Crypto

Let’s Debate is our interactive feature where Experts delve deeper into timely financial and restructuring topics. We’re joined by Tom Braziel, Founder of 507 Capital, Jason New, Managing Partner of Novawulf Digital Management, Mo Meghji, Managing Partner of M3 Partners, Vlad Jelisavcic, Manager at Cherokee Acquisition, all experts in their field.

Bitcoin prices have plummeted 70% from their 2021 highs. Stablecoin Luna collapsed in May and the dominos have fallen one by one. $10 billion crypto hedge fund Three Arrows Capital collapsed in July, followed by the crash of crypto lenders $5 billion+ Voyager and $8 billion+ Celsius. The collapse of $30 billion+ FTX was rapid and stunning, playing out over ten days in November resulting in insolvency cases in multiple jurisdictions. Contagion and follow-up continue with crypto trading platform, Block-fi’s filing for bankruptcy just yesterday. We are going to talk about how we’ve gotten here and, more importantly, where we go from here.

So, let’s debate Crypto.

We’re very excited to have them with us today. Let’s start with how we got here. Tom?

Tom Braziel: Going back, there was the collapse of Mount Gox dating back to March of 2014 in Japan, and Quadriga, a crypto-ponzi scheme, that collapsed in 2020. Mount Gox was the market when it went under. The exchange controlled over 75% of bitcoin trading so it was all the contagion in one event.

While those were one-off unique situations in the sense of there wasn’t a lot of contagion, they definitely showed the inherent problems with these “business modelsâ€. I use air quotes because these are kind of strange business models, taking in short-term deposits and running it like a hedge fund where you’re making all kind of crazy investments. And that really showed the vulnerability in what was happening.

What happened isn’t so different from any other financial cycle where lenders get over their heels and loan books sour with lending practices that run a-muck. And, I think that’s in my mind how we got here. In a bear market you’ll see a lot of people swimming naked and that’s what we’re seeing now.

Jason New: If I can chime in.

Tom Braziel: Go for it.

Jason New: Crypto at its foundation is first and foremost decentralized and transparent and that was the vision and that is still, for many people, the vision, but it morphed into centralized and non-transparent finance. So, entities like Celsius, FTX Alameda, Three Arrows, you know, Genesis, they’re all centralized and non-transparent so the underlying assets are crypto, but these entities are sort of something else. On the one hand they made the same mistakes that countless firms have made in the past. But the two differences are, one, they’re essentially all private with no public financials, and two, there’s no regulation at all. So you have a new asset class that is non-transparent and private with no public financials and no regulation. And, so the worst imaginable things that could happen, did happen.

Alameda was basically a hedge fund. Celsius was effectively an asset management firm, whether you want to call it a hedge fund or something else. Voyager was kind of like that. Block-fi was sort of like Celsius in that it was basically a lender. So, let’s just focus on the centralized lending entities for a second and leave the exchanges like FTX aside. These other entities were basically alternative asset managers, which you and I have worked in. You generally need something called a private placement memorandum. You generally target very sophisticated investors, qualified purchasers. Typically in the U.S., maybe you can get to a lower threshold and go to accredited investors, but even that requires incremental hoops to jump through. We can’t just put up a website and say go wire me your money. It doesn’t work that way.

But here, these platforms or asset managers were able to raise capital from unaccredited, retail investors and then turn around and invest that money in any way they saw fit with no disclosure. I think the very threshold of the way money was raised in and of itself was a starting point for disaster and a problem, and that’s where the regulators should’ve stepped in after a nanosecond.

Mo Meghji: Jason, let me pick up on that. I’m sort of the newest entrant to this space as a restructuring advisor over the last six months and it’s frankly shocking, to see the lack of regulation, the lack of any governmental oversight allowing that to happen and the number of retail, individual retail customers, who were huge believers in decentralized finance who just handed their money off to these various sort of promoters.

Despite all of the contagion, I don’t know when the Government’s going to step in and start attacking this, but if ever there was a poster child for an industry where there’s been incredible amounts of delay that cause losses for individual investors this is it primarily through lack of regulation.

Dan Kamensky: Financial innovation isn’t inherently bad, though. Why did this go so far off the rails?

Jason New: So let’s just say you have an unregulated entity that got this big pool of money right? That’s not necessarily bad. Some of the largest alternative asset managers in the world are generally not that tightly regulated. A lot of them have very good disclosure, but then on top of that you have an industry, for the most part that was developed by tech entrepreneurs, and just because you’re a good teche ntrepreneur does not necessarily make you a good steward of people’s capital and a good investor. And I think this industry has conflated the two. People who are good software developers or engineers can build good tech platforms. But taking someone’s money and investing that is a completely different skill set. Just because you can build an airplane doesn’t mean you can fly it. And I think this whole sector has trusted a lot of money to people with very limited, if any, background in managing other people’s capital.

And they had next to no controls from a risk perspective: typical things like concentration limits, diversity requirements, reserves, liquidity measure. None of this was in place. Counterparty risk, the whole space didn’t understand counterparty risk. Now, it’s obviously learning a very tough lesson in that regard, but I think you’ve got to take a step back and ask what is this entity supposed to do at its core and if it’s a tech franchise, great, have a tech person run it. If it’s an investing business, have somebody who has a skill set to invest run an investing company.

Tom Braziel: The remarkable speed in which these crypto platforms grew didn’t allow the infrastructure to keep pace with it. So the companies that I have exposure to, and there’s three or four right now, with billions of dollars of assets still operating kind of like a startup.

And if you ask basic infrastructure and corporate management questions, they’re like, well, we had planned to do that but we haven’t hired somebody for that or it’s somebody’s job, but it’s a part-time job on very core issues like asset management, risk management, underwriting criteria etcetera etcetera.

Dan Kamensky: Mo, you’ve managed many financial firms, as CRO at Capmark, and as a senior member of the management team at Springleaf Financial. You have real-life experience with how a well-run financial institution should be run. What’s the difference?

Mo Meghji: Massive. And look, to be fair, those companies also ran into problems in the global financial crisis, so they certainly weren’t immune from making mistakes. The issue here is they don’t have the infrastructure or a skill-set of people being able to manage financial risk, which was critical to these platforms.

Dan Kamensky: So, you have this unregulated industry with capital freely flowing into it with an unproven currency. Jason, help us understand the role of tokens and stablecoins in this new financial ecosystem.

Jason New: Within this space, you have utility tokens and governance tokens that may have very thin float and then there’s meme tokens like Dogecoin. You’ve had an industry that’s bent over backwards to try to avoid these tokens being deemed to be a security because there’s regulation associated with that. And, I think that is a big problem in and of itself, because if you want a token to have real value, to have cash flow potentially associated with it, then it may look more like a security. But how do you say what a token is worth when you have no true contractual entitlement to anything. A lot of people in this space mistake having equity in a platform with having a governance token, and those two are not the same. That’s a problem. The same is true for Celsius. You have people who thought the CEL token represented equity value in Celsius. It did not. If there were better disclosure there would be more understanding what these tokens represent – that they may have no intrinsic value to begin with. A function of a stablecoin is effectively to allow a fiat currency to transact on a blockchain. I think the purpose behind stablecoins has a lot of merit. Then let’s talk about different types of stablecoins. Stablecoins, like USDC, which is Circle, or USDT, which is Tether, are two of the larger stablecoins that are backed by collateral. Some people have raised issues with respect to Tether’s collateral. Whether or not that is sufficient and safe enough to warrant a one-to-one ratio. Circle has been incredibly transparent with respect to what they have backing it. People hate to use the analogy to a money market, but I’m going to use that term, so you should have collateral that looks pretty similar to a money market, in my opinion, backing a true, stablecoin. Whether it’s T-bills or, short-dated liquid collateral, but not Chinese CP by way of example. Stablecoins serve a real purpose. Whether or not they should be paying a yield in a four percent risk-free environment is a different topic and we’ll see where that evolves, but I actually think there’s a real purpose for that. You look at Terra, Luna’s algorithmic stablecoin. The intention with Terra was to create something that is stable that trades on a one-to-one basis, but it was effectively being balanced by two separate tokens, for lack of a better word. And that failed colossally in the context of Terra Luna and that breaking down, I would say, is one of the first dominos that fell in this ecosystem. That was something that started a cascade effect.

Dan Kamensky: Jason, to your point, what were some of the other sources of financial contagion besides Terra’s Luna at the time that the market didn’t fully appreciate?

Jason New: You essentially had the re-hypothetication of collateral and lending within a relatively small ecosystem to each other. It would be like if an upstream E&P company was not only drilling, but they were also lending to other E&P companies. There’s a lot of risk when you are that contained within the same space and then you weigh on top of that a lot of leverage, you have a lot of problems. Another source of risk was as I understand it, certain firms were also putting on levered bets on the Grayscale Bitcoin Trust. [The Grayscale Bitcoin Trust is an approximate $10bn investment vehicle intended to provide secondary market exposure to Bitcoin that has traded at a premium and discount to its NAV over time.
And then, you know, if you look at Voyager, they ran an incredibly concentrated loan book when they filed. A third of their exposure was to Three Arrows Capital, but if you go back even nine months, a third of their loan book was to Alameda. Who has a third of their loan exposure to one counterparty ever? It’s just unheard of, let alone when the other two-thirds of your loan book is effectively related to the same underlying collateral when you really take a step back. So you had massive issuer concentration risk and then essentially massive industry concentration risk. Maybe industry concentration risk is what people understood and were bargaining for. But I don’t think anybody thought it was prudent to have one-third of your loan book at a point in time to one counterparty, particularly a highly levered hedge fund that had no disclosure.

Tom Braziel: I think there were always rumors about concentration risk within certain people’s loan books, but just backing up for a second, isn’t restructuring and bankruptcy littered with niche finance companies getting over their skis and this is no different in some respects. These companies are very fintech heavy, with people under 30 building technology. That’s fine if it’s a startup and no one cares about your software, but it’s kinda different if you’ve raised a billion dollars in customer assets. It’s kind of like taking venture capital and putting it in a finance wrapper. The difference is, is like you’re now financially killing people.

Dan Kamensky: The other aspect to these relationships I want to cover is the customer relationship with these financial institutions. Much of the retail shock has been a realization that much of your collateral was held in margin accounts and used for other investing activities.

Tom Braziel: I think the Terms of Service are important, right? And then, you know, is if this is a creditor debtor relationship or is this a custodial relationship? In the case of FTX, the Terms of Service squarely treat the customer relationship as a trust issue, and there are probably breaches of trust for dipping into that money versus Celsius and Voyager, excluding, of course, the custody accounts, and Celsius looking more like general unsecured creditors. I think this is all good for crypto because we just need real legal protections for asset owners of digital assets. Changes to the Uniform Commercial Code will be further pushed along by what’s happened and hopefully, good regulation, and case law develops. One of the biggest issues in terms of where we are today, is it possible to have a real custody relationship in the crypto space?

Jason New: I believe so. I think if you look at someone like an Anchorage with an OCC license or an NYDIG with a New York State Banking license, or probably soon to be a BNY Mellon who’s seeking to custody Bitcoin. Fidelity’s getting into that business. Coinbase seems to be operating as a legitimate custodian, So I think it’s clearly possible. People shouldn’t be forced to read the fine print. If you are saying I want someone to hold my crypto for me because I don’t want to hold it myself and I’m willing to pay a custody fee for that. I think that is a very viable business. They need to be truly held in custody.
There needs to be real disclosure around that and really, really tight regulation, because that is basically giving people your capital and I think that’s doable with the right regulatory framework. Do I think exchanges should be separate from custodial businesses? Without a doubt. And even if let’s just say that Celsius and Voyager and these other institutions disclosure to their customers might have been really clear if you read the terms of service in real close detail, but what was said on You Tube and everywhere else was not, hey, you’re giving up your crypto to be comingled. It was, unbank yourself and put your money on a platform and you can take your money back whenever you want. That’s what was said.

Mo Meghji: Just to that point, there were a bunch of very surprised people who had expected their crypto at Celsius to essentially be parked for them, based on the founder’s promotion, and social media marketing. It’s really the combination of those that put too much trust into unregulated entities and, for lack of a better word, cowboys operating in an environment with bitcoin prices at all time highs. But as soon as prices fell, it became a real issue and created a run on the bank. And now you’re seeing contagion across the system all over the place.

Dan Kamensky: Vlad, you’ve spoken and written a lot about some of these contagion risks. Anything to add?

Vlad Jelisavcic: I think the structures that evolved were analogous to the interlocking asset liability structures that you see in traditional finance. But to Jason’s point, there was no real diversification in underlying assets. All crypto assets are pretty closely correlated directionally, price-wise and so you have this domino-like effect of, interlocking assets and liabilities with no public financials, no regulation. And a cultural lack of asset management expertise and risk management practices. At this point though, I think the whales are all like dead, or maybe in the case of Genesis dying. We keep on talking about the same firms, just shows you how concentrated the ecosystem was. Alameda, Genesis, FTX and many of those firms are now bankrupt or in restructuring negotiations, so there’s not many whales left. Most of the dominoes have fallen. Right?

Mo Meghji: So while I agree with Vlad that the big whales may have been identified and fallen, there are a lot of minnows that are sort of walking around wounded and could get crushed and killed in the process.

Dan Kamensky: So, Terra’s algorithmic stablecoin collapses causing by some estimates $30 to $40 billion of value destruction. How does that spread out into the wider crypto ecosystem?

Tom Braziel: If you look at the solvency of Three Arrows Capital, their other exposure, what they had in their loan book, they were dead anyway with the drop in bitcoin prices. The collapse of Luna was the straw that broke the camel’s back at Three Arrows Capital.

Dan Kamensky: Similar to other financial crises you then see there is an enormous liquidity vacuum creating an enormous asset liability mismatch. Here, because the token itself was used as collateral in what people viewed as highly liquid lending transactions, it exposed an incredible amount of leverage and counterparty risk in the system. So, let’s talk about FTX and what made its downfall so different.

Jason New: Exchanges should not have a hole in their balance sheet. Celsius and Voyager, hey, maybe they made some bad loans. That can happen to anybody. That happens to private credit firms. It happens to hedge funds but they’ve got the right liability structure to withstand that and they’ve got time. These firms didn’t have that, but FTX was just, I think, completely different. You’ve got the profile that Sam Bankman-Fried had as being one of the biggest faces in the industry is obviously a big black-eye, particularly given his profile in DC. The fact that you’ve got a lot of very reputable VCs investing money at very high valuations into FTX, that also is quite a bit different. I don’t think the way they raised money was appropriate. I don’t think the risk controls were appropriate. Time will tell whether there was blatant fraud, but when you pivot into FTX and Alameda, you had a firm that was run by people with no experience. I don’t care how smart they are. They had no experience, clearly did not have respect for corporate governance and formalities in any context. And, as soon as they faced a problem, they misappropriated funds, maybe not aware of at the time, but clearly there was a misappropriation of customer monies to fill holes elsewhere within an organization. Oftentimes in corporate entities that were different than the entities where the money supposedly resided. That feels a lot more to me like real fraud. We’ve all seen this before. You tend to see frauds come out in instances where asset values go down dramatically. This is not the first time. It will certainly not be the last. But here the order of magnitude’s pretty extreme and I just think the fact that it happened so quickly the whole industry now is getting the light shine shown on it with respect to asset liability mismatches. If you’re sitting around with money on any of these platforms outside of a true custodial relationship, why would you do that? And I think that sort of questioning is happening across institutional investors but more so retail is causing some of these runs on the banks.

Tom Braziel: I would describe this as the ultimate case of youthful intelligence combined with no experience and supreme confidence with the ability to go out and sell in this remarkable way that Sam Bankman-Fried was able to do and create an aura I can do no wrong.

Dan Kamensky: The other element I want to just touch on here is the concept that there was this native token called FTT and the role that played. As you all know, on November 2 Alameda’s balance sheet leaked showing that they held approximately $6 billion of FTT on their own balance sheet.

Vlad Jelisavcic: FTT was a token created by FTX whose value was primarily related to FTX by using some of their earnings to buy back the FTT token and some other ancillary benefits. But ultimately the problem with any entity using that asset as collateral is if the FTX firm fails, the token they issued goes to zero as well. It’s not an arms-length asset issued by a third party. The relationship between Alameda and FTX through the FTT token sort of rhymes with the Terra relationship with algorithmic stablecoin Luna because the two entities were dependent on one another and the failure of one, you know, because of the heavy dependence and the large ownership stakes in each other, eventually led to the demise of both. Until the revelations came out, just days before FTX’s bankruptcy filing, that Alameda’s solvency was so dependent on a token issued by their affiliate, that was not previously known to the market. Obviously it was improper, again undisclosed.

Dan Kamensky: Are there other similar risks like that within the system, or is this something unique?

Jason New: Within this space, you have tokens that may have very thin floats and large market caps, some of which may have reasonable floats and even larger market caps. But, here we had a thin float and a large market cap. A seasoned risk manager would not lend against that. If Goldman was their prime broker they are not going to take some thinly traded stock as collateral and give you a lot of leverage against it. That’s not going to happen. I don’t know if was stupidity or just real naïvete across this industry when they were looking at collateral value, because it was propped up by thin trading, and that is problematic.

Dan Kamensky: Has the industry learned that lesson? If you were to open up the books of other financial institutions within the crypto space, would you still see these illiquid tokens collateralizing their exposures?

Jason New: I would hope they’d be mitigating that risk aggressively right now.

Tom Braziel: The issue you have, especially with FTX, is the side-by-side nature of the market-maker Alameda and the exchange FTX, and the undisclosed relationships between the two. But because these weren’t deemed securities and securities laws didn’t apply there was probably a lot of market manipulation and intermingling between the two. Take a look at crypto-lender Genesis and crypto-exchange Gemini. I think the problems that they ran into with their loan book is they were trying to serve two masters, they were trying to get flow for OTC exchange partner Gemini and yet they were providing loans to their participants. It’s sort of like trying to get your bread buttered on both sides and then
all of a sudden you lose money on the loan side but still owe the other side. And I think that’s probably part of the problem of what Alameda and FTX ran into.

Jason New: You see that in traditional finance as well. If the guy who runs financial sponsors at a
bank is more powerful than the guy who runs credit underwriting at the bank, the odds are that bank makes some bad loans to some financial sponsors over time. But here it’s even worse because these firms probably don’t have risk management to begin with and they were looking more to subsidizing or growing other parts of their business than risk managing their existing business. The growth model works much better in technology because people don’t get hurt that bad; but in financial services, it doesn’t work because people get hurt and so we need to see a change in behavior.

Dan Kamensky: Tom, you mentioned Genesis. Genesis reportedly owes $900 million to Gemini and is considering restructuring options. What do you think happens there?

Tom Braziel: It would seem like the OTC trading and lending business are just over their skis. It’s been widely reported and I don’t think those guys are idiots and are going to throw good money after bad. If it’s an unsolvable balance sheet, they’re just going to file it. I actually think in a way it could be better for the crypto markets, because it gets the uncertainty of how deep this cut goes because some fear it could reach to the parent company Digital Currency Group (DCG). That could be really bad for the industry.
DCG has an enormous amount of projects they’re investors in and just how you see it in FTX, where there’s an enormous amount of Solana projects that are exposed. I’m not saying those projects are dead, but it’s clearly a huge headwind when your leading investor goes under. That could be a real problem for a lot of other projects if DCG goes down.

Mo Meghji: I would say we’re seeing a lot of issues in the mining sector. All the companies that are doing crypto mining and have built a big infrastructure are obviously struggling at the current price of Bitcoin. There’s going to be some dominoes to fall there, but that hasn’t fully played out yet.

Jason New: I view mining companies a bit like E&P companies blowing up when oil goes to $ 25 and it’s kind of to be expected just given the nature of their business. Financial leverage in those businesses is always tough. I think Genesis will be interesting because they seem to be run more like a traditional finance company to a degree, but just given the systemic dominos following, Genesis may not be able to withstand what’s happening.

Dan Kamensky: We’re coming to an end. Let’s end on predictions. Next shoe to drop? What does this industry look like in five years from now? What about other areas of concern from here. Tether is a stablecoin with a $50 billion market cap. Is that an area of concern?

Vlad Jelisavcic: Some people have expressed a concern with their collateral. Time will tell. I do think if you’re advertising yourself as a collateral-backed stablecoin, you should have very clean collateral. As we all know from being in this distressed debt investing business after a crisis, the strong get stronger and so well-managed, compliant, transparent firms will get stronger. So companies like Coinbase will get stronger. Obviously there’s going to be moreregulation. This is in many ways analogous to the stock market crash of and all of regulation and legislation that came out in the early to mid-1930s. A lot of the abusive practices that we’re seeing in crypto today are very similar to what was happening in equity markets in the mid-to-late 1920s. Lastly, I think the relative market share of DeFi [decentralized finance] will increase, so we see truly distributed, peer to peer, transparent on chain products and software.

Jason New: I think you’ll start to see a real distinction between firms that are building technological rails for financial institutions and other firms. That, to me, is a different business model than firms that are taking in people’s capital. The former, I think can run really fast and build on the way, and if you break a few things it’s not great, but it’s not the end of the world. The latter, I think, needs to be managed much more like a traditional financial institution, and I think you’ll start to see that distinction. As I think about investing in this space, I think very differently about things that look like asset management firms or banks or custodians versus things that look like technology. You can make money on both, but I think they’re each going to have different regulatory constraints around them and warrant different regulatory constraints.

Mo Meghji: It’s absolutely critical that regulation come in as soon as possible and then obviously
scale will matter for long term success, particularly on the asset management side, because I think a big reason why a lot of these companies have failed is lack of scale and lack of diversification.

Tom Braziel: I think what we’re seeing is how important the on-ramps and off-ramps of crypto are. And you’re seeing why decentralized finance is so interesting and important for the future, as many of the dominoes are centralized finance entities. So, what I would see is more decentralized onroads and offroads to the crypto ecosystem.

Jason New: I think if decentralized finance is really going to grow we will have some of the same
problems we are seeing today. It’s still up to a person, somebody or some group of people
to come up with the credit metrics that the protocol or that smart contract adheres to, and
that credit judgment will be made by an individual at its core, and then it’s just rolled out
with a different technological platform. And if those algorithms don’t work then that’s a problem.

Dan Kamensky: This was a great conversation. Thank you.